United States Senate PERMANENT SUBCOMMITTEE ON INVESTIGATIONS Committee on Homeland Security and Governmental Affairs Carl Levin, Chairman John McCain, Ranking Minority Member JPMORGAN CHASE WHALE TRADES: A CASE HISTORY OF DERIVATIVES RISKS AND ABUSES MAJORITY AND MINORITY STAFF REPORT PERMANENT SUBCOMMITTEE ON INVESTIGATIONS UNITED STATES SENATE RELEASED IN CONJUNCTION WITH THE PERMANENT SUBCOMMITTEE ON INVESTIGATIONS MARCH 15, 2013 HEARING SENATOR CARL LEVIN Chairman SENATOR JOHN McCAIN Ranking Minority Member PERMANENT SUBCOMMITTEE ON INVESTIGATIONS ELISE J. BEAN Staff Director and Chief Counsel ALLISON F. MURPHY Counsel ZACHARY I. SCHRAM Senior Counsel ELIZABETH V. BALTZAN Former Congressional Fellow ERIC S. WALKER Former Detailee HENRY J. KERNER Staff Director and Chief Counsel to the Minority BRAD M. PATOUT Senior Policy Advisor to the Minority STEPHANIE HALL Counsel to the Minority SCOTT D. WITTMANN Research Assistant to the Minority FERAS SLEIMAN TODD PHILLIPS Law Clerk Law Clerk ADAM HENDERSON Professional Staff Member MARY D. ROBERTSON Chief Clerk 3/14/13 (9:30am) Permanent Subcommittee on Investigations 199 Russell Senate Office Building – Washington, D.C. 20510 Majority: 202/224-9505 – Minority: 202/224-3721 Web Address: http://www.hsgac.senate.gov/subcommittees/investigations JPMORGAN CHASE WHALE TRADES: A CASE HISTORY OF DERIVATIVES RISKS AND ABUSES TABLE OF CONTENTS I. EXECUTIVE SUMMARY ................................................. 2 A. Subcommittee Investigation. .......................................... 2 B. Overview . .......................................................... 3 (1) Increasing Risk. ................................................. 3 (2) Hiding Losses. ................................................... 5 (3) Disregarding Risk .................................................. 7 (4) Avoiding and Conducting OCC Oversight . 8 (5) Misinforming Investors, Regulators, and the Public . 10 C. Whale Trade Case History ............................................... 14 D. Findings of Facts . ..................................................... 15 (1) Increased Risk Without Notice to Regulators . 15 (2) Mischaracterized High Risk Trading as Hedging . 15 (3) Hid Massive Losses ................................................. 15 (4) Disregarded Risk ................................................... 15 (5) Dodged OCC Oversight.............................................. 15 (6) Failed Regulatory Oversight .......................................... 16 (7) Mischaracterized the Portfolio......................................... 16 E. Recommendations ...................................................... 16 (1) Require Derivatives Performance Data . 16 (2) Require Contemporaneous Hedge Documentation . 16 (3) Strengthen Credit Derivative Valuations . 16 (4) Investigate Risk Limit Breaches ....................................... 17 (5) Investigate Models That Substantially Lower Risk . 17 (6) Implement Merkley-Levin Provisions ................................... 17 (7) Enhance Derivative Capital Charges .................................... 17 II. BACKGROUND .......................................................... 18 A. JPMorgan Chase & Company ............................................ 18 B. Chief Investment Office ................................................. 21 C. Office of the Comptroller of the Currency .................................. 25 D. Capital Requirements ................................................... 27 D. Credit Derivatives ...................................................... 29 III. INCREASING RISK ...................................................... 35 A. Origins of the Synthetic Credit Portfolio ................................... 36 B. Purpose of the Synthetic Credit Portfolio: Undocumented, Unclear, and Subject to Change ...................................................... 42 i C. SCP Trading .......................................................... 49 (1) The Early Years: 2006 to 2010 ........................................ 49 (2) 2011 SCP Expansion ................................................ 50 (3) 2011 SCP Profit From Bankruptcies .................................... 53 (4) SCP Size and Revenues .............................................. 56 (5) SCP Trader Compensation............................................ 57 (6) 2012 Opens with Order to Reduce RWA ................................ 60 (7) Eastman Kodak Default .............................................. 64 (8) Credit Market Rally Revalues SCP ..................................... 65 (9) Four Options to Reshape the SCP ...................................... 67 (10) Decision to Go Long ................................................ 72 (11) Adoption of 2012 Trading Strategy ..................................... 73 D. SCP’s Increasing Risk and Losses ......................................... 75 (1) January 2012 ...................................................... 76 (2) February 2012 ..................................................... 78 (3) March 2012 ....................................................... 81 (4) Phones Down ...................................................... 85 E. Unmasking JPMorgan Chase ............................................ 90 F. Dismantling the SCP .................................................... 92 G. Analysis .............................................................. 94 IV. HIDING LOSSES ......................................................... 96 A. Background ........................................................... 99 (1) Valuing Derivatives In General ........................................ 99 (2) Valuing Derivatives at JPMorgan Chase . 101 B. Mismarking the CIO Credit Derivatives ...................................106 (1) Mismarking Begins .................................................106 (2) Mismarking Peaks ..................................................110 (3) Increasing the Reported Losses ........................................116 (4) Trading Stopped....................................................123 (5) Accusing the Investment Bank.........................................124 (6) Mismarking Continued ..............................................130 C. Ending the Mismarking .................................................136 D. Reviewing the SCP Valuations ...........................................140 E. Admitting the Mismarking ...............................................151 F. Analysis ..............................................................153 V. DISREGARDING LIMITS .................................................154 A. Background ...........................................................155 B. Risk Management Structure at CIO .......................................158 C. CIO Risk Management Personnel .........................................160 D. Disregarding CIO Risk Metrics ...........................................165 (1) Disregarding the VaR Limit...........................................166 ii (a) Background ....................................................166 (b)Developing a New VaR Model .....................................168 (c) Breaching the VaR Limit ..........................................172 (d)Raising the VaR Limit Temporarily .................................177 (e) Winning Approval of the New VaR Model . 180 (f) Using the New VaR Model to Increase Risk . 182 (g)Failing to Lower the VaR Limit.....................................183 (h) Operating and Implementation Failures . 185 (2) Ignoring Comprehensive Risk Measure . 187 (a) Background ....................................................187 (b)Challenging the CRM Results ......................................188 (c) Gaming the CRM Model ..........................................192 (3) Ignoring Repeated Breaches of Credit Spread Risk Limits . 198 (a) Breaching CS01 Risk Limit ........................................198 (b)Breaching CSW10% Risk Limit ....................................205 (4) Overlooking Stress Loss Limit Breaches . 207 (5) Disregarding Stop Loss Advisories .....................................208 (6) Missing Concentration Limits .........................................211 D. Responding to the Risk Limit Failures .....................................213 E. Analysis ..............................................................215 VI. AVOIDING AND CONDUCTING OCC OVERSIGHT .........................216 A. Overview of OCC's Oversight Role ........................................218 B. Pre-2012: Avoiding OCC Oversight As the SCP Develops .....................220 (1) 2006-2009: Minimizing OCC Oversight As SCP Expands . 221 (2) 2010: Resisting OCC Examination Results . 222 (3) 2011: Missing SCP Red Flags ........................................225 C. 2012: Dodging OCC Oversight While SCP Losses Mount .....................227 (1) Misinforming OCC that SCP Book to be Reduced . 227 (2) Failing to Provide OCC with CIO Data..................................230 (3) Failing to Investigate Risk Limit Breaches . 232 (4) Miscasting Long Acquisitions As Risk Reducing . 234 D. 2012: Resisting OCC Oversight Even After Whale Trades Became Public ......236 (1) Providing OCC with Limited or Incorrect Information . 237 (2) Updating OCC Only When Losses About to Become Public . 241 (3) Hiding Problems with the Marks .......................................244 E. OCC Aftermath ........................................................246 F. Analysis .............................................................251 VII. MISINFORMING INVESTORS,